Divyang Shah, Senior IFR Strategist
The steepening of money market curves in both UK and eurozone has reversed slightly while in FX both the GBP and EUR weakened sharply against the USD.
The combination of flatter curves and weaker currency has helped to reverse the tightening in monetary conditions over the course of the last few weeks.
The question is whether forward guidance will be sufficient to prevent UK and eurozone assets from being swept along with the tide as the Fed likely tapers QE as early as this September? #
The Fed can lend a helping hand by improving its own communication as it has failed to convince financial markets that:
1) an eventual end to QE does not mean that rate hikes are around the corner and
2) that tapering is about not wanting to add to existing accommodative policy and they have no intention of removing accommodative policy.
Forward guidance from the BoE and ECB will allow money markets to be divorced even if bond markets continue to stay correlated. The most interesting aspect of the market today is that money markets are listening, despite the fact that the BoE and Fed have delivered softer versions of forward guidance. Contrast this with the Fed where they have a hard version of forward guidance that is based on numerical thresholds yet they are still finding it difficult to convince financial markets.
Below we summarise the BoE and ECB outcomes with some market colour.
BoE - Carney kicks communication off with a post-meeting statement
The BoE departed from its usual action and delivered a post-meeting statement that included forward guidance. The objective is clearly not only to improve communication but to set out the BoE’s view that rates are to stay lower for longer. Specifically the BoE cites recent improvement in growth and has factored in that inflation will rise over the coming months but it is the forward guidance that is most significant.
The BoE acknowledges the “significant upward movement in market interest rates” and how this will weigh on the outlook for growth and inflation. The key paragraph is that “in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy”. The use of the word “significant” and “not warranted” are all soft forms of forward guidance.
A harder form of forward guidance is still under discussion and the BoE says that the chancellor had requested that alongside the august inflation report the committee also provides an assessment of the case for “adopting some form of forward guidance, including the possible use of intermediate thresholds”. The latter is akin to the current forward guidance used by the Fed where numerical thresholds are used with regards to inflation and unemployment.
We don’t expect QE or a rate cut but the focus for the MPC has shifted toward trying to flatten money market rates and in turn nurture what is still a very fragile and infant recovery.
ECB - Forward guidance, what does extended period mean?
The ECB has delivered a slightly less soft version of forward guidance by saying that the governing council expects key rates to remain at “present or lower levels for an extended period of time”.
This is much more specific than its previous forward guidance that simply reflected the accommodative nature of monetary policy. The fact that the decision on forward guidance was unanimous is another positive as it reflects the fact that all of the ECB are on the same page with regards to the need to maintain current stimulus even if they differ on whether further stimulus is required.
The question is what does “extended period” mean? A lack of clarity on this is likely to dampen the impact of forward guidance but by linking the market rate expectations to the real economy the ECB can create some positive feedbacks and allow market expectations to adjust.
On top of delivering forward guidance we now have Draghi backing up the language with the ECB having a extensive discussion about a possible rate cut. In addition to this Draghi is making sure that the emphasis is on “key rates” which means that they are not ruling out the possibility of a negative deposit rate or even the refi rate being at a floor of 0.50%. The addition of “or lower” in the forward guidance is intended to allow an asymmetry which helps to cement the forward guidance even if there is uncertainty as to what “extended period” means.
The impact of forward guidance can be seen on the EONIA curve as the whole curve flattens with 12x24 down 13bp to 0.23%. We had a receive 12x24 EONIA on at 0.45% and we will look to take profit on this at current levels for a paper profit of 22bp.
